Operating and Financial Decision Making - Essay Example

Operating and Financial Decision Making Introduction: The effects of carrying costs are an important determinant for profitability and use of revenue in large companies. It is seen that carrying large inventories has the following impacts on financial statements of the Company: PROFIT and LOSS ACCOUNT BALANCE SHEET CASH FLOW Item Higher / lower / same? Item Higher / lower / same? Item Higher / lower / same? Turnover same Fixed assets same Cash balance lower Cost of goods sold higher Cash lower Working capital lower Interest on overdraft / loans higher Debtors same Cash reserves same Net profit lower Stock higher Creditors higher Figure 1: Effects of Carrying High levels of Stocks (Step 3 - To Stock or not to Stock). The following are the costs associated with inventory Particulars Approx Annual cost as a percentage of inventory value 1. Carrying Costs Cost of capital tied up Storage and handling costs Insurance Property taxes Depreciation and obsolescence II Ordering, shipping and receiving costs Cost of placing orders, including production and set up costs Shipping and handling costs III Cost of running short Loss of sales Loss of customer goodwill Disruption of production schedules 12.0% 0.5% 0.5% 1.0% 12.0% 26.0% Varies 2.5% Varies Varies Varies Costs associated with Inventory (Eugene and Michael. P. 860. 2004). The matter relates to the Inventory costs relating to Cameron Balloons Ltd, a 100% owned subsidiary company of Cameron Holdings Ltd. There are three aspects of inventory and they are: Stock of Raw Materials, Stock of Work-in-Progress and finally stock of Finished goods. There are certain aspects characteristic, to Cameron Balloons relating to their inventory holdings: 1. As per the abbreviated balance sheet dated 31.1.2006, the stock levels on 31/1/2007 was £ 1382,592 as compared to £ 1132,505 on 31/1/2006. Thus, there has been an increase of 22.08% over the previous year. 2. However, the Debtors on 31/1/2007 was £508,282 as compared to £ 329,097 in the previous year ending 31/1/2006, an increase of nearly 55% . Therefore it could be said that increased level of inventory has given rise to sales and debtor build up also, which is a good for Cameron Balloons also. Moreover, it is seen that the inventory components of stock in the company consists of many small items supplied by different manufacturers . Among these, items like envelope, envelope scoop, padded cover, inflator fans, basket, burners and cylinders form the main constituents of the finished product – the inflatable balloons. It is seen for these crucial stock items, there may be only one or two approved suppliers. Therefore, it needs to be ensured that delivery and quality aspects need to be strictly looked into, since the safety aspects of these air balloons cannot be compromised since it involves human safety and security. Moreover, if it is needed to change suppliers of crucial items, it become necessary to get recertified from the approval body for safety and security which may not be an easy task. Therefore, it is felt that given the fact that there are many sub assembly parts and components involved in the making of an air balloon, it is necessary to maintain a higher level of stock inventories. Lead time: The manufacture of hot air balloons involves a specialist task entailing maximum safety and standard control adherence, and nothing could be left a chance in the manufacture of hot air balloons. In the case of ordering being placed for resupply, the delivery may take time, depending upon the type of raw materials and the time required for reorders. For the supply of fabrics, the lead time may be around 8 weeks. Again, in the case of other items, the lead time would be a period ranging from 3 days to 3 months, depending upon market conditions and availability of materials reordered. Sometimes it may happen that the items may not be available in ready stocks with the vendors/suppliers, and therefore, it may become necessary for them to have it supplied from a third party, which is a time consuming matter. In the case of Cameron Balloons, it is seen that around 10 major authorized and certified suppliers, supply around 50% of the inventory requirements. Changeover of vendors or reduction in lead time may compromise with the quality aspects, which may not be in the best business interests of the Company. The main idea therefore would be to maintain a suitable and appropriate level of inventory commensurating with the level of production, marketing and dispatch of goods to customers. Therefore, it becomes necessary not to have too little levels which may impact sales and deliveries or too much, which may imply higher interest rates, storage and carrying costs. The critical balance between the need for replenishing and stocking supplies and the need to secure economic gains through a judicious mix of investments and economic ordering is necessary to achieve long term benefits in this significant area of corporate activity. “Although holding inventories involves blocking of a firm’s funds and the costs of storage and handling, every business enterprise has to maintain a certain level of inventories to facilitate uninterrupted production and smooth running of business. In the absence of inventories a firm will have to make purchases as soon as it receives orders. It will mean loss of time and delays in execution of orders which sometimes may cause loss of customers and business. A firm also needs to maintain inventories to reduce ordering costs and avail quantity discounts.” (Gupta and Sharma P 24-32. 2006). The Cameron Balloon Company should strive to achieve optimum levels of stocks through scientific analysis and implementation of appropriate strategic inventory controls using the Economic Ordering Quantity concept. This concept is significant because the quantity should not be too small or to big. The EOQ, is the quantity that needs to be replenished and is economically viable. (Stock Control System. Fixed re-order stock level). There are two aspects to EOQ, the ordering costs and the varying costs. In this case study of Cameron Balloon, it is assumed that the supply of the goods, through strategic vendor relationship buildup, is good and replenishments cans be made, whenever these are needed. Moreover, it may be also assumed that prices of the balloon components are steady and the quantities also cogent. The derivation of the following formulae would determine the EOQ for each item: EOQ = √ 2 AS, where A= Annual consumption in £ I S = Cost of placing an order I= Inventory carrying costs of one unit This would provide an appropriate reordering quantity for each stock item. It is however necessary that a full assessment of the inventory systems in vogue in the company is assessed before such systems are operationalized. Just in Time: This technology is used by the giant automaker, Toyota, and is emulated by the other companies as well. It involves the co-ordination and synchronization between the consumption of inventories and its reordering. Only the most required materials required for the production process is kept in inventory, and stocks are maintained just enough to cater to the planned production, thus ensuring the barest minimum in inventory carrying costs. The net result is enhanced productivity, better resource management and achievement of overall economies of scale. It is however necessary that, before Just In time systems are implemented in the organization, it should reinforce the strategic vendor relationships and procurement policies, to ensure that planned and programmed production targets could be achieved through the use of JIT methods. The adaptation of JIT systems in Cameron Balloon Co would depend upon how well it would be possible to redefine job functions and educate the workforce, regarding the substantial cost savings and efficiently benefits that could accrue through the use of JIT. In a case study of a manufacturing unit in USA, the Company was having cash flow problems and it was nursing inventory worth $ 1.1M to support Turnover of just $8M. A strategic decision to inject JIT resulted in lowering of its raw material and Work in Progress to $ 750,000 and freed up $350,000 of cash, even as sales doubled.” (Eugene and Michael: P 861. 2004). Schonberger defines JIT as “to produce and deliver finished goods just in time to be sold, sub-assemblies just in time to be assembled into finished goods, fabricates parts just in time to go into sub-assemblies and purchased materials just in time to be transformed into fabricated parts.” (Gupta and Sharma. P 24-42. 2006). Another aspect with regard to Cameron would be with regard to purchasing techniques and this envisages the use of procurement techniques and buying decision making. It is necessary that the best quality and quantity items are selected by way of the best buying methods with speedy delivery and the induction of reinforced supplier relationships which is most economical and beneficial for the Company. Through the use of a centralized purchasing system for inventories, it is possible to attain economies for bulk purchases at discounted rates, and also to make proper planned policies and efforts for successful negotiating for pricing and other factors. The reorder level indicates the order at which the ordering has to be initiated . As has been said, the level at which the stocks if unreplenished, would go to the danger levels and thus adversely affect the production,. At the shop floor level, the reorder level could be displayed by a red indicator in the Bins; when the stock levels are full, the redline is not visible, but once the stocks begin to deplete, the red line becomes visible and therefore, it becomes necessary to reorder. However, in the case of Cameron Balloons Ltd., since a computerised method of inventory control is being maintained, it is possible to achieve all the figures for all the stock items with regard to maximum levels, minimum levels, reordering levels and danger levels and through the use of software, it could be possible for automatic reordering once the reordering level is reached. Another aspect with regard to this is that the co-ordination aspects between the shopfloor level, the stores dept. and the purchase dept must be maintained at optimum levels. Therefore, effective communication networks need to be established to ensure that production does not suffer due to lack of raw material or production inputs and this is the prime responsibility of the procurement dept to ensure that machines are not idle or unproductive work is being carried out in the shopfloor level. The aspect of high inventory carrying need to be seen in the light of sales , especially in the case of a Company like Cameron Balloons. This is because this balloon company does not function like other manufacturing units. The product is unique and requires a large variety of raw materials and passes through different stages of production like cutting, making and implanting of artwork designing, Sealing of the different segments to form the envelope, and the installation of the baskets and the burners inside the envelope etc. At each stage a rigorous quality control system and checking is required, since it is not possible to make any changes in a final balloon product, and therefore , all quanlity checks and controls need to be done at the manufacturing stages itslef. In this way, it is a unique product, which has several stages of batch costing and process costing elements involved. Theproduct is also subject to rigorous quality control by the concerned govrnment departments, since this product involves risks to human lives, and therefore, the maximum safety, security and protection measures have to be embedded in the product. It is also necessary to have a backup plan, in the event, the balloon fails in mid air or mechanical failures develop, if left unattended, could cause loss of human lives. However it is necessary to see that the following aspects regarding inventories need to be maintained and strictluy reviewed : 1. All balloons should be made according to the templates, and wastages, damages and handling losses are cut down to the barest minimum, if necessary an Operating Manual has to be designed and implemented, which would detail the various processess and the best way in which production could be carried with the least costs and procedural wastes 2. A proper Material Requisition system needs to be enforced with details of the Job number and the quantity of materilas required. It needs to be ensured that all unused materials should be returned to the stores, through return memos. Full accounting has to be rendered for the used materials and for cutting wastages etc 3. A proper authorisation for materials sent to production, to work in progress and in the final products needs to be established and cost controls for various assemblies and sub-assemblies need to be done. 4. It would be better if a system of JIT could be established at the shop floor level which would bring down the wastages and promote efficiencies and improved quality. When used along with TQM (Total Quality Management) it is believed that JIT could serve the purpose of reinforced and effective management systems with regard to inventory controls. 5. The inventories are always calculated as a proportion of sales. In this case study, in the absence of data on turnover, it has not been able to calculate the inventory ratios. The Inventory turnover is seen as Sales/Inventories and the standard industry average is 9. (Eugene and Michael. P.88. 2004). The degree of efficiency and operatinal effectiveness of inventories could be furher strenthened by regular reports to the top management by the concerned stock officials. “For effective inventory control, the management should be kept informed with the latest stock position of different items. This is usually done by preparing periodical inventory reports. These reports should contain all information necessary for managerial action. On the basis of these reports managaement takes corrective action wherever necessary. The more frequently these reports are prepared the less will be the chances of lapse in the administrarion of inventories.” (Gupta and Sharma. P 24-40. 2006). Conclusion: In the case of companies, it must be said that the inventory levels are determined by the turnover and the procurement policies pursued by the top management.It needs to be emphasised that, for an effective inventory policy and executory programme, a strategic balance has to be struck between the needs of the production crew and its implications on the bottom line of the Company. Therefore Cameron Balloons Ltd. need not make extra investments in Inventories on the basis of notional risks and perceived increases in stock prices, but needs to realistically programe its inventories in sync with market demands and customer preferences. In the long run, however, it is deemed necessary that Cameron Ballons Ltd evolve a long term strategic growth plan covering all areas, including inventory holdings and controls, which could significantly impact upon its business prospects and market development in global terms, and could also pave the way for enhanced growth in future years. Bibliography Tables EUGENE, Brigham F. and MICHAEL, Ehrhardt C (2004). Inventory Costs. Financial Management: Theory and Practice. 10th Edition. Thomson Asia Pvt.Ltd.. Singapore. P. 860. Step 3 - To stock or not to stock. Biz/ed. Last accessed 4 December 2007 at: http://www.bized.co.uk/virtual/cb/factory/purchasing/worksheets2.htm Stock Control System. Fixed re-order stock level. Biz/ed. Last accessed 4 December 2007 at: http://www.bized.co.uk/virtual/cb/factory/purchasing/theories2.htm Text EUGENE, Brigham F. and MICHAEL, Ehrhardt C (2004). Inventory Control Systems. Financial Management: Theory and Practice. 10th Edition. Thomson Asia Pvt.Ltd. Singapore. P. 860. EUGENE, Brigham F. and MICHAEL, Ehrhardt C (2004). Inventory Control Systems. Financial Management: Theory and Practice. 10th Edition. Thomson Asia Pvt.Ltd. Singapore. P. 88. GUPTA, Shashi K and SHARMA, R. K (2006). Inventory Reports. Tools and Techniques of Inventory Management : Management Accounting: Principles and Practice. 10th edition. Kalyani Publishers: New Delhi. P. 24-40. GUPTA, Shashi K. and R. K. Sharma (2006). Inventory Management: Purpose/Benefits of holding Inventories. Management Accounting: Principles and Practice. Kalyani Publishers. New Delhi. 10th edition. P 24-32. GUPTA, Shashi K and SHARMA, R. K (2006). Tools and Techniques of Inventory Management: Just in Time (JIT) inventory control system: Management Accounting: Principles and Practice. 10th edition. Kalyani Publishers. New Delhi. P. 24-42. Read More